09 September 2010

Sebi vs economics, who will win?

I have a piece in today's Economic Times on why SEBI's mutual fund regulation fights economics and how it is killing the industry. Here is an excerpt:

From June to August 2009, Sebi changed the rules of the game to curb mis-selling and conflict of interest which arises out of a distributor selling the most lucrative product. The regulator outlawed entry loads (a charge on purchase), capped exit load at 1% of redemptions (a charge on sale) which could previously have gone up to 7% and barred AMCs from paying distributors a commission out of the initial kitty.

Distributors now need to negotiate with investors the initial commission and the amount must be paid by separate cheque to the distributor. This is of course great for investors who don’t need to shell out an inbuilt fee with their purchase and also the rule change reduces the conflict of interest of selling with the motivation of earning commissions.

Unfortunately, the law of unintended consequences results in the product not being sold at all and the industry has shrunk dramatically since the rule change was introduced.


So where did Sebi go wrong with this seemingly benevolent action? The answer is economics 101. Imagine going to the market to buy a packet of biscuits, and imagine a law which says the packet must be sold at cost, and that must be the cost to the retailer with a virtual ban on the manufacturer to pay the retailer any mark up.

Now imagine that the same law says that the profit must be negotiated between the consumer and the retailer. The system is unlikely to work which is why such laws don’t exist for ordinary products.

A version of this economics resulted in the fall of communism. The theory of getting products at cost to the consumer would result in the product not being sold, and in further consequence, the product will not be manufactured leading in turn to demand remaining unsatisfied.

The conflict of interest exists in the market for biscuits as well, how often will a retailer sell you the product with the lowest margins? That is hardly an argument for selling at cost with negotiable profits.

The Sebi board agenda note, which discusses the issue seems to solve the issue at hand inappropriately and uses partial material from the equivalent US law. First, the note goes into issues of transparency of commission structure, but ends up outlawing commissions instead.


Forth, the note ignores public comments of which less than 1% support the move, on the grounds that the comments seem to be rigged. Fifth, it relies only on one regulation from the US regulations of mutual funds ignoring that the US system allows not only what is known as 12b-1 distribution fees (which is capped at 1%), but a whole host of other fees like purchase fees, redemption fees, exchange fees, account fees and operating fees many of which are shared with distributors.

An entry load, which can go up to 8.5%, is given by the AMC to the distributor, an exit load which also goes to the distributor has no cap. Thus to rely on the cap on one out of a dozen fees from the US context is inappropriate and to outlaw distributor commissions after talking of transparency is not even solving the issue at hand.


Instead of going back to business as usual , a good middle ground could be to mandate clear disclosures in simple language in the offer documents and maintain the overall caps on expenses, while remaining agnostic as to how much of the expenses and commissions are shared with the distributor. We don’t need a wonderful operation with the patient dead.

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